Tag Archives: carbon

The Prospect Of A Warm Winter Hurts DTE Energy’s Short-Term Outlook

Summary Michigan electric and natural gas utility DTE Energy reported Q3 earnings that beat on EPS despite missing on revenue due to hot temperatures and low fuel prices. The company’s long-term outlook, which was already strong, continued to improve as national policy and low natural gas prices increased the value of its NEXUS pipeline project. Its short-term outlook has diminished, however, as the presence of a strong El Nino will likely result in a warm winter and a cool, early summer in its service area. The company’s shares are no longer so undervalued as to merit investment given this short-term outlook, although investors should consider selling near-the-money calls due to its weak short-term outlook. Michigan electric and natural gas utility DTE Energy (NYSE: DTE ) reported Q3 earnings last week that beat solidly on EPS despite missing on revenue. In a bullish article on the company written back in June, I noted that its operating outlook was not nearly as negative as investor sentiment was at the time, concluding that: Its shares certainly appear to be more attractive based on forward valuations than they were at the beginning of the year, a result that can be largely attributed to the prevalence of bearish sentiment toward dividend stocks in anticipation of one or more interest rate hikes by the Federal Reserve later in the year. With a 3.7% yield, an improved operating environment, and plans to increase regulated capacity while expanding its non-regulated operations, DTE Energy is an attractive long investment candidate. In the subsequent four months, the share price increased by 12%, although it has settled a bit over the last two trading days. While I continue to like the company’s long-term operating environment, the development of a strong El Nino that is now expected to last well into Q2 2016 can be expected to impact its short-term earnings. This article re-evaluates DTE Energy as a potential long investment in light of these changing conditions. Q3 Earnings Report DTE Energy reported Q3 revenue of $2.6 billion (see table), virtually unchanged from the previous year, and missing the consensus analyst estimate by $80 million. The miss came despite the presence of a hot quarter in the company’s service area, with 48% more cooling degree days occurring compared to the previous year, albeit only 4% more than the long-term average. This gain was partially offset by the presence of self-imposed reduced rates resulting from the lower energy prices during the quarter on a YoY basis. Its electric sales volume to industrial customers also declined by 2% YoY, resulting in a total volume reduction of 1% over the same period. The service area’s warm weather persisted into the end of the quarter as well, resulting in a 53% YoY reduction to heating degree days, albeit from a much smaller base compared to cooling degree days. DTE Energy Financials (non-adjusted) Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Revenue ($MM) 2,598.0 2,268.0 2,984.0 3,078.0 2,595.0 Gross income ($MM) 1,545.0 1,326.0 1,586.0 1,749.0 1,476.0 Net income ($MM) 265.0 109.0 273.0 299.0 156.0 Diluted EPS ($) 1.47 0.61 1.53 1.69 0.88 EBITDA ($MM) 678.0 466.0 715.0 832.0 578.0 Source: Morningstar (2015) The aforementioned presence of much lower energy prices during the quarter was reflected in reduced operating expense, which declined by 1% YoY. Operating income came in at $440 million, or an increase of 84% compared to the previous year, due to the presence of flat revenues and lower costs. Net income came in at $264 million, up 70% compared to the previous year, resulting in a diluted EPS result of $1.47 compared to $0.88 YoY. The EPS result included a beneficial $0.07 mark-to-market impact that, if ignored, resulted in an adjusted diluted EPS result of $1.40 that beat the analyst consensus by $0.15. EBITDA came in at $678 million, up from $578 million in the previous year. The company’s quarterly dividend was 6% higher YoY, reflecting its strong performance over the TTM period. DTE Energy’s Q3 earnings strength was reflected across almost all of its segments. DTE Electric reported a diluted EPS of $1.19, up from $0.76 YoY. The Gas Storage and Pipelines segment came in second at $0.15, up from $0.11 YoY, on strong demand for its pipeline and gathering services resulting from the presence of very low natural gas prices compared to the previous year. DTE Gas reported an EPS of -$0.06 that represented a gain over the previous year of $0.03 despite the presence of fewer heating degree days in the most recent quarter. Only the Power and Industrial Projects segment reported lower earnings, which declined from $0.21 to $0.17 YoY – a move that the company attributed to lower steel earnings. Finally, DTE Energy announced that it had increased its 33% stake in its NEXUS natural gas pipeline joint venture with Spectra Energy (NYSE: SE ) to 50%. Progress on the pipeline has continued over the last four months, and while the company’s increased stake caused its expected cost contribution to rise to $1 billion, the pipeline is expected to be in service by Q4 2017. Contracting was recently completed for the pipe itself, and the FERC filing is expected to be done in the current quarter. Outlook DTE Energy’s management felt confident after the Q3 earnings release to reaffirm its FY 2015 guidance range of $4.65-4.91 and increase the midpoint of the guidance to $4.78. While this result would represent a sequential decline from the company’s bumper FY 2014 earnings, it would still be one of its strongest on record. Furthermore, the company also released its first FY 2016 guidance with an EPS range of $4.80-5.05 – a move that it based on continued economic growth and falling unemployment in its service area. Existing investors will be pleased to know that management is also targeting dividend growth equal to EPS growth, suggesting a 3% increase in FY 2016 based on the midpoint of the guidance. While DTE Energy’s long-term outlook is very optimistic, I believe the company will struggle to achieve the midpoint of its FY 2016 EPS range. The reason for this is the development of one of the strongest El Ninos in the last half of a century over the last several months. These weather events are commonly associated with warmer-than-normal winter weather in the northern half of the U.S., including Michigan , and cooler-than-normal weather in the southern half. Historical records show that El Nino events are associated with substantially above-average temperatures in Michigan between October and May, in which case DTE Energy’s service area can expect to experience fewer heating degree days than normal in Q4 2015 and Q1 and Q2 2016. Furthermore, late Q2 will probably be both colder and wetter than normal, raising the prospects of a reduced number of cooling degree days during early summer. DTE Energy’s guidance already assumes that Q4 2015’s earnings will be lower on a YoY basis just due to the presence of abnormally cold weather in Q4 2014. That said, El Nino threatens to derail the company’s FY 2016 guidance by causing its H1 2016 earnings to come in below expectations. DTE Energy’s operating outlook improves after FY 2016, however, due to a combination of recent regulatory and market developments. Its Gas Storage and Pipelines segment is becoming an important contributor to earnings, and this is likely to continue so long as natural gas prices remain low relative to historical prices. The company’s JV NEXUS pipeline was already expected to provide a large boost to the segment’s contribution. Low natural gas prices will increase its expectations, however, by driving demand for natural gas as power plant fuel at the expense of coal. The recently announced acquisition of Piedmont Natural Gas (NYSE: PNY ) by Duke Energy (NYSE: DUK ) exemplified the larger trend by U.S. utilities to convert coal-fired plants to cheaper natural gas. Looking beyond just the current natural gas pricing environment, however, NEXUS is poised to benefit from two recent developments. The first is continued economic growth in Michigan, including Detroit. While the state and the city both suffered mightily in the aftermath of the 2008 financial crisis, with the latter being hit especially hard by the abandonment of high-margin SUVs and other fuel-inefficient vehicles by cost-conscious drivers, the persistent presence of low petroleum prices over the last three quarters has caused the U.S. automobile industry to stage a strong comeback. Michigan’s economy has rebounded as well, with the Chicago Fed recently proclaiming it the fastest-growing economy in the Midwest. Falling unemployment and continued economic growth will cause natural gas demand in DTE Energy’s service area to also increase, with NEXUS ultimately making further such increases possible. The U.S. Environmental Protection Agency’s recently released Clean Power Plan will increase demand for natural gas pipelines in Michigan and the upper Midwest. The Clean Power Plan requires each state to reduce its carbon intensity (units of greenhouse gas emissions per unit of electricity generated) over the next decade. Michigan must achieve a 24% reduction to its carbon intensity by 2024 and a 39% reduction by 2030. Importantly, its final carbon intensity target is very close to the carbon intensity of a gas-fired power plant, meaning that the state’s utilities can contribute by switching from coal to natural gas. This is already being done across the U.S. due to return of cheap natural gas, and the Clean Power Plan is expected to simply deliver a legal impetus to a market trend that already exists. This will serve to further increase demand for the type of service that the NEXUS pipeline will provide upon its completion. Valuation The consensus analyst estimates for DTE Energy’s diluted EPS results in FY 2015 have risen slightly over the last 90 days, while those for FY 2016 have remained stable. The FY 2015 consensus estimate has increased from $4.74 to $4.79, in line with management’s midpoint guidance, while the FY 2016 estimate has stayed flat at $4.96, slightly above the midpoint guidance. Based on a price of $82 at the time of writing, the shares are trading at a trailing P/E ratio of 16.1x on a non-adjusted basis and forward P/E ratios of 17.1x and 16.5x, respectively. All three of these ratios are higher than in June, but still low relative to their respective 3-year ranges. That said, I do expect that the company will struggle to achieve the FY 2016 consensus estimate if El Nino has a similar impact on Michigan’s winter temperatures to those that it has had in the past, in which case the shares are not clearly undervalued at this time. Conclusion DTE Energy reported solid Q3 earnings earlier this week as hot temperatures in the second half of the summer and low energy prices contributed to a large YoY earnings gain. Management was upbeat in the company’s Q3 earnings report and subsequent earnings call, outlining the rebounding nature of its service area’s economy, continued opportunities for additional future capex, and progress on its NEXUS pipeline JV. I further believe that the persistence of low energy prices and low natural gas prices in particular as well as the release of the Clean Power Plan will provide additional support for the new pipeline when it comes on-line. That is still two years away, however, and DTE Energy must first face the prospect of two consecutive warmer-than-normal winter quarters followed by a cooler-than-normal summer quarter as a strong El Nino makes its presence felt. Given the increase to the company’s share price that has occurred over the last four months and the prospect of multiple bearish quarters, I do not recommend buying DTE shares at this time. Existing shareholders who bought back in June and don’t want to incur the tax implications of a short-term sale, however, should consider selling near-the-money call options at this point to take advantage of the fact that the company’s near-term outlook is not as positive as its longer-term outlook. DTE Energy remains an attractive investment opportunity due to economic recovery in its service and its own strategic moves to benefit from rising natural gas demand, but it is not one that provides a sufficient margin of safety for me to recommend it as a “buy” at this time.

A Unique Geographic Position Makes Allete An Attractive Utility

Summary Midwest utility holding company ALLETE has encountered substantial share price volatility in 2015 so far due to broader utilities volatility and its own diversification efforts. Concerns about the company’s exposure to coal mining and coal-fired electricity have risen in recent months as the federal government has proposed to crack down on power plants’ carbon emissions. In the short term, ALLETE is insulated from commodities volatility since its major electricity customers supply the strengthening U.S. auto manufacturing sector. In the long term, the company is positioned to translate carbon restrictions into rate base growth and new projects for its clean energy development subsidiary. The company’s share valuation and dividend yield are already attractive. Given its recent volatility, however, potential investors will likely be able to get rock-bottom valuations by waiting a bit longer. Midwest utility holding company ALLETE, Inc. (NYSE: ALE ) has experienced an abnormally high amount of share price volatility in 2015 to date. The company’s share price set a new all-time high early in the year before shedding 24% of its value in seesaw action that has persisted until now. While some of this volatility can be attributed to the uncertainty that has impacted the broader utilities sector regarding future interest rate movements, ALLETE’s heavy exposure to coal and coal-fired electric generation assets has caused investors to turn bearish given the current federal U.S. regulatory environment. Furthermore, the company differs from most of its peers in that its primary customer base consists of a handful of large industrial facilities rather than a large number of small, residential homes. This article evaluates ALLETE as a potential long investment opportunity in light of these factors. ALLETE at a glance Headquartered in Duluth, Minnesota, ALLETE Inc. is a utility holding company that comprises six wholly-owned subsidiaries in addition to an 8% stake worth $115 million in the broader regulated venture American Transmission Co. Minnesota Power is the most important of these subsidiaries and, as a regulated electric utility, it provides electricity to 144,000 residential customers, 16 municipalities, and several large industrial customers in northern Minnesota. It generates sufficient electricity to meet the demand of its 26,000 service area via multiple sources, the largest of which (62% of the total) is coal. Another 29% is derived from power purchase agreements, of which a large fraction is also generated from coal, and hydro. In all Minnesota Power has a total generating capacity of 1723 MW. Minnesota Power operates within a relatively favorable regulatory scheme that includes a 10.4% allowed return on equity, cost and fuel price riders, and a $2.6 billion rate base. More than 50% of its electric sales are attributable to industrial customers, including five large producers of taconite, an important iron-bearing rock that is an important raw material input in the steel industry. The industry in the company’s service area has remained buoyant of late and the company expects new industrial customers to increase demand by up to 600 MW. Furthermore, the state of Minnesota borders states that have some of the most abundant wind resources in the country, and the subsidiary expects to meet at least some of this demand via investments in new wind capacity in North Dakota. Minnesota Power expects to average roughly $250 million in annual capex through 2018 in part to meet this demand growth, providing support for future rate base increases. ALLETE’s non-regulated subsidiary BNI Coal, which operates closely with Minnesota Power, owns and operates a lignite mine in North Dakota. This mine yields roughly 4 million tons of coal annually that is sold to electric coops in the area that in turn have power purchase agreements with Minnesota Power. Under ordinary circumstances, it would appear to be optimally placed, thanks in large part to the fact that its “cost plus” contracts run through 2037, to benefit from growing demand for electricity (and thus generation fuel) in Minnesota Power’s service area. This would be true if its name was “BNI Gas” instead of “BNI Coal.” Given coal’s rapid fall from grace in the eyes of federal regulators, however, the subsidiary runs the risk of becoming a burden on ALLETE’s balance sheet over the next several years. To the company’s credit, ALLETE responded to the unpopularity of fossil fuels in general and coal in particular by forming ALLETE Clean Energy in 2011. This non-regulated subsidiary is responsible for the development and acquisition of wind, hydro, solar, biomass, and shale gas (hence its use of the word “clean” rather than “renewable” in its name) projects. Recognizing the existence of a broad resource nexus between energy and water, ALLETE also acquired U.S. Water Services, which is a small water management firm based in Minnesota, in February 2015. Finally, ALLETE owns a number of smaller subsidiaries that operate in different sectors. Superior Water, Light, & Power is a regulated electric, water, and natural gas utility that operates within a service area consisting of Superior, Wisconsin and the immediate vicinity. This subsidiary utility has an attractive allowed return on equity of 10.9%, although both its rate and customer bases are only a fraction of those of Minnesota Power, making it a small contributor to ALLETE’s consolidated earnings. ALLETE Properties is a subsidiary that owns three property developments in Florida. The incongruous nature of its operations and generation of losses of late have prompted its parent company to investigate gradual sales of the subsidiary’s assets that will allow it to exit the property sector while maximizing returns. ALLETE is also a participant in the CapX2020 initiative, which is focused on the upgrading of transmission lines. ALLETE’s consolidated operations are ultimately strongly influenced by the regulated utilities sector. Its regulated utilities operations were responsible for 88% of its consolidated revenue in FY 2014. Furthermore, with the exception of ALLETE Properties, its non-regulated subsidiaries operate closely within the regulated utilities sector, complementing ALLETE’s consolidated revenues and earnings. This has allowed the parent company to report a respectable EPS CAGR of 6.7% CAGR since 2010. Its dividend has increased by 15% over the same period even as its payout ratio has declined from 76% to 65%. Nor is ALLETE exposed entirely to Minnesota, as its regulated operations now encompass North Dakota, South Dakota, and Wisconsin as well while its clean energy operations reach as far afield as Oregon (hydro) and Pennsylvania (shale). Q2 earnings ALLETE reported Q2 consolidated revenue of $232.3 million (see table), up by 24% YoY and beating the consensus analyst estimate by $20.3 million. The increase and beat were mostly attributable to the inclusion of full quarter results from US Water Services and Clean Energy for the first time. The revenue number was also aided by the presence of a cost recovery rider and the commencement of a new power sales agreement in June 2014. The company’s retail numbers came in low, with retail electric sales in terms of kWh sold falling by 9.7% YoY, although the consolidated sales number increased by 7.2% over the same period due to power purchase agreements. The average price of regulated electricity increased by 7% compared to the previous year, offsetting the negative impact of lower retail sales volume on revenue. The presence of a fuel cost rider kept regulated revenue from increasing, however. ALLETE financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 323.3 320.0 290.7 288.9 260.7 Gross income ($MM) 179.6 187.9 203.3 200.0 177.1 Net income ($MM) 22.5 39.9 32.9 41.6 16.8 Diluted EPS ($) 0.46 0.85 0.72 0.97 0.40 EBITDA ($MM) 87.3 100.6 95.0 101.7 69.1 Source: Morningstar (2015). ALLETE’s cost of revenue increased by 72% YoY to $143.7 million due to the aforementioned subsidiary additions. Gross income remained relatively flat at $179.6 million YoY due to this increase despite the much stronger revenue result. Net income came in at $22.5 million, up by 33% from the previous year. Diluted EPS came in at $0.46 versus $0.40 YoY, missing the consensus estimate by $0.02. The EPS included acquisition fees of $0.02, without which the consensus estimate would have been matched, as well as dilution equal to $0.07. EBITDA increased from $69.1 million to $87.3 million YoY. Finally, ALLETE’s dividend in Q2 represented a 3.1% increase over the previous year. Outlook ALLETE’s management announced during the Q2 earnings call that it was increasing its FY 2015 guidance up to $3.20-$3.40 despite the Q2 earnings miss to account for proceeds from the sale of a wind farm that its subsidiary ALLETE Clean Energy is constructing. This result would represent its strongest annual earnings in more than a decade while also continuing a multi-year trend. The company’s current year earnings are due in no small part to the resilience of Minnesota’s taconite producers in the midst of a very bearish global steel market. While falling demand for industrial materials in the developing world in general and China in particular has pummeled steel indices (steel ETF prices are hovering around their early 2009 lows), Minnesota’s taconite producers mainly supply domestic steel producers that in turn supply U.S. automakers. ALLETE’s management has reported few signs of weakness among its large industrial customers as a result, with only one customer idling its facility. ALLETE’s earnings are highly sensitive to electricity demand from taconite producers, with a 1 million ton per year change to taconite production having an impact of $0.03/share on the company’s diluted EPS. In fact, ALLETE’s heavy exposure to Minnesota’s taconite production could continue to be a boon in coming quarters. Petroleum prices fell sharply in Q4 2014 and Q1 2015 and, while they have rebounded a bit from their 2015 lows, they remain well below their earlier highs. Consumers have responded by buying new, less fuel-efficient vehicles, driving demand. This month’s auto sales are expected to be the highest for October since 2001, while 2015’s numbers are expected to be 5% higher than 2014’s. Cheap petroleum should therefore support ALLETE’s earnings via Minnesota Power by keeping taconite demand high. While I do expect crude prices to rebound, especially as the finances of OPEC members are squeezed ever tighter, it will take several quarters for any reduced demand for U.S. steel to be felt by ALLETE. In the longer term, ALLETE’s earnings have the potential to be substantially impacted by the Clean Power Plan that was recently unveiled by the U.S. Environmental Protection Agency [EPA]. This new regulation requires each U.S. state to achieve predetermined reductions to the carbon intensity (greenhouse gas emissions per kWh of electricity generated) of their respective power plant sectors. Minnesota must achieve a large 24.5% reduction by 2024, while Iowa and South Dakota must achieve still larger reductions. While the EPA’s plan will not benefit all utilities, ALLETE is uniquely positioned due to the abundant wind resources near its service area and its new ALLETE Clean Energy subsidiary, the latter of which is already developing a reputation as a wind farm construction firm. ALLETE itself will need to shift away from coal towards renewables and, if this move is done properly (i.e., by building its own capacity rather than relying on power purchase agreements), it could support future capex. Beyond that, however, ALLETE Clean Energy should become a steadily larger contributor to consolidated earnings as utilities in the surrounding area also rely upon it to develop new renewables capacity. BNI Coal will suffer from weakening coal demand under this scenario, of course, and ALLETE itself could incur asset write-downs if it is required to send some of its coal-fired generation capacity into early retirement, but on balance, I expect the company to benefit under the Clean Power Plan. Valuation The analyst consensus estimate for ALLETE’s FY 2015 EPS has increased over the last 90 days in response to the resilience of its industrial customers and recent asset sale while the FY 2016 EPS estimate has remained relatively flat. The FY 2015 estimate has increased from $3.11 to $3.26 while the FY 2016 estimate has been revised slightly lower from $3.39 to $3.37. Based on a share price at the time of writing of $50.36, the company’s shares are trading at a trailing P/E ratio of 16.3x and forward ratios of 15.4x and 14.9x for FY 2015 and FY 2016, respectively. While the trailing ratio is in the middle of its historical range, both of the forward ratios are near the bottom of their respective 5-year ranges, having actually been at the bottom as recently as last month. Conclusion ALLETE’s share price has been all over the place in 2015 to date in response to the combination of a bearish sentiment in the broader utilities sector and its own diversification efforts. This latter move is the one that investors will want to pay the most attention to since it has the potential to provide the company with the type of growth options that are not available to most of its peers. The company’s heavy exposure to coal mining and coal-fired generation is a concern at a time when both activities are attracting the ire of regulators. This disadvantage is more than offset by the company’s twin advantages of close access to abundant wind energy resources and a subsidiary that contributes to consolidated earnings by developing and selling wind farms. Meanwhile, the EPA’s Clean Power Plan will support the company’s future rate bases while driving demand for ALLETE Clean Energy’s services. ALLETE is an attractive long investment opportunity at present due to its 4% forward yield and relatively low valuation. Given the volatility that has characterized utilities in recent months, however, I would encourage potential investors to wait for the company’s share price to provide an additional margin of safety by trading at 14x FY 2016 earnings, or $47.18 based on the estimate available at the time of writing, before initiating a new position. Initiating a short put position could be an attractive strategy here at this time.

MGE Energy’s Investors Can Expect Lower Earnings In 2016 Due To El Nino

Summary Wisconsin electric and natural gas utility MGE Energy’s share price has struggled over the last three quarters in response to mild summer weather and the prospect of higher interest rates. The company’s valuations remain high despite the recent share price decline due to its impressive history of dividend and earnings increases as well as a strong credit rating. While MGE Energy is in a better position than its peers to handle higher interest rates, this year’s strong El Nino will negatively impact its earnings in FY 2016. Potential investors should wait for the impact of a warmer-than-average winter and early spring to be reflected by lower valuations before initiating any long investments in this top-performing utility. Investors in Wisconsin electric and natural gas utility MGE Energy (NASDAQ: MGEE ) saw their shares fall in value by as much as 24% in the first three quarters of the year as declining earnings disappointed investors, although the price has since recovered somewhat following the Federal Reserve’s decision to postpone an anticipated interest rate increase. The company, which boasts an impressive track record on both dividends and annual earnings growth, faces short-term headwinds with the potential to negatively impact its earnings over the next three quarters. This article discusses those headwinds and evaluates MGE Energy as a potential long investment opportunity in light of them. MGE Energy at a glance Headquartered in Madison, Wisconsin, MGE Energy provides natural gas and electric services to the Madison metro area. It also provides natural gas to parts of southwest Wisconsin. The company operates as a holding company for a number of energy-related subsidiaries. The original entity, Madison Gas & Electric, provides the electric and natural gas utility services to 143,000 electric and 149,000 natural gas customers. MGE Power owns electric generation assets, including 250 MW of natural gas-fired power plants, 137 MW of wind power assets, and minority stakes in large coal-fired plants. MGE Transco Investment owns a minority stake in American Transmission Company. Finally, the holding company owns a number of small LLCs engaged in energy services operations. The company’s utility operations are responsible for the large majority of its earnings, generating 70% of its diluted EPS in the first half of 2015, while the transmission stake contributed a further 8%. Residential and commercial customers provide the large majority of its utility revenues, with industrial customers only contributing a small share. MGE Energy has experienced strong EPS growth in recent years, with its FY 2014 result coming in 40% above its FY 2010 result following several consecutive years of increases. The company has also been a dividend stalwart, achieving a 3.6% dividend CAGR since 1909 and annual increases in each of the last 39 years. In recent years, the annual growth of its dividend has increased to 4% and, while its payout ratio has fallen from 66% in FY 2009 to 48% last year, this has been a function of the dividend simply not keeping up with rapid earnings growth rather than a declining payout amount (although current investors have been disappointed to see the industry average hold steady at 60% at the same time). Not surprisingly in light of these increases, MGE Energy’s total return has outperformed both the Dow Jones Utility Average as well as the broader DJIA over the trailing 3-, 5-, and 10-year periods. The company’s earnings and dividend growth have been made possible by large capex over the last six years that caused its electric assets to increase by 45% and its natural gas assets to increase by 25% over the period. The contribution of capex to earnings was supported by the fact that MGE Energy’s operations fall within a favorable regulatory scheme that employs both forward test years to determine rate base increases and fuel recovery mechanisms that minimize the impact of energy price volatility on earnings. Capex growth has slowed more recently, however, as electric capex peaked at $100 million in FY 2013 before falling to an estimated $62 million in the current year, although natural gas capex has partially offset this decline by increasing from $16 million to $22 million over the same period. Q2 earnings report MGE Energy reported a mixed bag in its Q2 earnings report released in August. Revenue came in at $122.1 million, down 5.2% YoY from $128.8 million. The decline was due to the presence of very mild temperatures in June especially, with the number of cooling degree-days present during the quarter coming in 31% lower YoY and 11% lower than the long-term average. The average temperature in June was 67 degrees F, down from 71 degrees F in the previous year. The cooler early summer caused electricity consumption to fall as residential customers in particular did not turn their air conditioners on as frequently, and the company reported 1.6% fewer MWh sold in the first half of the year, although the presence of higher rates over the same period offset this. Mild temperatures in early spring compared to the previous year’s extreme cold caused Q2’s number of heating degree-days to also decline on a YoY basis, however, resulting in the net decrease to quarterly revenue. MGE Energy financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 122.1 170.1 145.7 135.1 128.8 Gross income ($MM) 81.5 88.5 88.3 93.0 79.8 Net income ($MM) 13.5 18.3 15.2 23.3 14.1 Diluted EPS ($) 0.39 0.53 0.44 0.67 0.41 EBITDA ($MM) 35.0 42.7 40.1 50.5 34.5 Source: Morningstar (2015). Gross profit increased despite the revenue decline to $81.5 million from $79.8 million YoY as sharply lower energy prices reduced the company’s cost of revenue by 17%. Operating income declined YoY, however, from $24.4 million to $24 million, due to increases to both O&M and depreciation, the former by $1.3 million and the latter by $0.9 million. Net income fell by a similar amount from $14.1 million, or $0.41 diluted EPS, to $13.5 million, or $0.39 diluted EPS, as a result. There was no analyst consensus estimate due to a lack of coverage but the EPS result would have likely been a miss due to MGE Energy’s record of earnings growth and the adverse weather conditions that contributed to the YoY decline. EBITDA did rise from $34.5 million to $35 million over the same period, however, demonstrating the impact that depreciation had on the EPS decline. While the company’s sparse earnings report did not go into detail, earnings declines resulting from higher O&M and depreciation costs commonly signify the presence of regulatory lag, as a lack of such lag causes higher rates to offset the cost increases via additional revenues. Outlook U.S. utilities are currently faced with two short-term and one long-term events that are likely to have a notable impact on their future earnings. The first of these, and the one that has received the most public attention, is the looming interest rate increase by the U.S. Federal Reserve. Most utilities drive future earnings growth via large capex amounts that are ultimately recovered in the form of rate increases. This capex is in turn financed largely by debt, making utilities very exposed to changes in interest rates compared to other public firms. The Dow Jones Utility Average swooned in the second half of August, falling by more than 10%, as spot interest rates for utilities began to escalate in anticipation of a rate hike by the Fed, leading investors to fear an imminent negative impact on utility earnings. The Average then recovered most of the lost ground after a worsening domestic economic outlook caused the Fed to postpone the hike until at least later in the year. While the inevitable rate hike will result in higher interest costs for MGE Energy, the utility is better positioned than most of its peers to handle higher rates. First, its leverage in terms of debt-to-capitalization has declined [pdf] from 43.5% in FY 2009 to 38.1% in FY 2014. More importantly, 80% of its long-term debt matures after FY 2019, providing it with flexibility in terms of when to refinance. Finally, the company is top among investor-owned utilities in terms of its credit ratings, boasting strong ratings and stable outlooks from both Moody’s and S&P. Credit spreads have increased sharply over the last 12 months, with the gap between AA- and BBB-rated yields growing by nearly half over the period. Maintaining its strong ratings will therefore minimize MGE Energy’s interest costs, both in absolute terms as well as relative to its peers, as interest rates move higher. The company’s short-term outlook moving into FY 2016 is also diminished somewhat, however, by the development of a strong El Nino event in recent months. The event, which is now forecast to be among the strongest on record, will bring cooler temperatures to the southern half of the U.S. but, counter-intuitively, warmer temperatures to the northern half, including MGE Energy’s service area. Historically Wisconsin has experienced substantially warmer than normal temperatures between October and May during years in which El Nino has been present. As Wisconsin residents know all too well, natural gas demand is quite high during the same period, making it very likely that the company’s natural gas utility segment will report weak retail sales over the next three quarters, especially on a YoY basis. MGE Energy’s long-term regulatory outlook recently shifted following the U.S. Environmental Protection Agency’s release of its Clean Power Plan, which requires each U.S. state to draft and implement plans for achieving preset reductions to the carbon intensity (i.e., pounds CO2 emitted per MWh of electricity generated) of their electric generation portfolios. Wisconsin’s electric sector continues to rely heavily on coal and the state is required [pdf] to make very large intensity reductions of 26% by 2022 and 41% by 2030. The ultimate reduction can largely be achieved by simply utilizing natural gas in place of coal and MGE Energy’s carbon intensity is cleaner than that of the state. I would not be surprised to see the large coal-fired plants that MGE Energy holds minority stakes in be placed on the chopping block as Wisconsin drafts its compliance plan, however, in which case the company will need to find alternative power providers. Ideally, this will take the form of rate-boosting in-house generation rather than power purchase agreements, although it is too soon to hazard a guess other than to say that the Clean Power Plan does inject uncertainty into the company’s long-term outlook. Valuation The analyst consensus for MGE Energy’s future diluted EPS results has remained unchanged over the last 90 days, although since only one analyst covers the company, the estimate should be viewed accordingly. The FY 2015 estimate is $2.25 and the FY 2016 estimate is $2.35; while the former would represent a slight YoY decline, the latter would represent a new high (albeit by only $0.03). Based on a share price at the time of writing of $41.90, the company is trading at a trailing P/E ratio of 20.6x and forward ratios of 18.6x and 17.8x for FY 2015 and FY 2016, respectively. All three of these ratios are quite high compared to both their respective historical ranges as well as those of the company’s peers. Conclusion MGE Energy’s share price has recovered since the beginning of September in response to the Federal Reserve’s decision to delay its anticipated interest rate increase, reflecting broader optimism in the utilities sector as a whole. While there is no denying the company’s stellar record in terms of both dividend as well as earnings growth, potential investors should approach it cautiously despite this price rebound. The company is well positioned to handle higher interest rates due to its excellent financial position but at the same time is exposed to El Nino-induced warm weather over the next three quarters, a period in which natural gas demand in its service area is normally high. Meteorologists’ forecasts of El Nino’s likelihood and duration have only strengthened over the last few months and I believe that MGE Energy will have a difficult time avoiding its second consecutive annual earnings decrease in FY 2016 as a result. The company’s shares are already overvalued on the assumption of earnings growth as it is. I encourage potential investors to wait for El Nino’s likely negative impacts to be reflected in the company’s share price before considering a long position in this otherwise excellent utility.